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Series 7

Portfolio Management - Market Indexes and Averages

All of the measures we've discussed thus far look at the market in general, but sometimes that is just too big a sample to work with. That is why market indexes and market averages exist. Both of these terms refer to ways of measuring how the value of a basket of selected stocks changes over time.

Strictly speaking, these terms are not interchangeable, but you frequently will hear an index mistakenly called an "average" and vice versa. An average is just what it sounds like: the sum of all the prices of all the shares in the basket divided by the number of shares in the basket. An index is a formula for measuring changes in a basket of stocks against a base date and value.

Market Average
An example of an average would be the famous Dow Jones Industrial Average, consisting of 30 "blue chip" stocks - that is, the stocks that most consistently return value to shareholders.
  • The DJIA
    • The Dow generally trades within the 10,000s, and the astute reader knows that few stocks ever trade in dollars of that magnitude, even if you added 30 of them together.
    • What makes the Dow a five-digit number is that its denominator is adjusted for stock splits, and there have been a lot since the Dow 30 was established in 1928.

    • Every time a blue-chip stock splits, the denominator goes down to compensate. Today the divided-by number is not 30; it is closer to 0.2.

    • To further muddy the waters, the components of the Dow today are not what they were when the average was founded: General Electric is the only original member still in the club, and Intel and Microsoft have superseded Union Carbide and Sears Roebuck.

    • Despite all these caveats, the Dow is still an average.
If you are curious to learn more about how the DJIA is calculated, the article Calculating the Dow Jones Industrial Average is for you.

Market Index
An example of an index would be the Standard & Poor's 500 Stock Composite. Because it is a broader measure - 500 components rather than 30 - many analysts find this a more useful tool than the Dow.
  • The S&P 500
    • The S&P 500 tends to trade in the 1000s. If the S&P was trading at 1178, this figure is not a dollar figure. It is a comparison to a date in the early 1940s when the index was established and assigned an arbitrary value of "10".

    • In other words, if the S&P was trading at 1178, the S&P stocks are worth 117.8 times what they were worth 60-odd years ago. (As impressive as that sounds, it works out to approximately 8.3% annual compounded growth - not bad, but not spectacular either.)
Get to know the most important market indexes, and the advantages and disadvantages of investing in them within the Index Investing tutorial.

Here are the most widely cited U.S. averages and indexes:

Dow Jones Industrial Average (Dow, DJIA) 30 blue-chip stocks; tracks the most consistently profitable U.S. companies
Standard & Poor\'s 500 Stock Composite (S&P 500) 500 largest U.S. companies by market capitalization; tracks the broader market of large-cap stocks
Nasdaq Composite More than 3,000 stocks, U.S. and international, that trade on the Nasdaq; most shares relate to the technology sector
Dow Jones Wilshire 5000 Total Market (Wilshire 5000) Approximately 5,000 U.S. stocks, although the precise components - and even the number of components - is considered proprietary; considered the broadest market measure
Russell 2000 2,000 U.S. small-cap stocks
PHLX Semiconductor (SOX) Philadelphia Stock Exchange\'s index of 19 companies involved in designing, distributing, manufacturing and selling semiconductors
Dow Transports 20 U.S. companies, mostly airlines, delivery services, trucking fleets and railroads
Dow Utilities 15 U.S. utilities, mostly generators and distributors of electricity
NYSE Composite Comprised of all stocks trading on the NYSE

Next: Technical vs. Fundamental Analysis »


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